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Thursday, September 18, 2014

In Praise of China’s New Normal

by Yao Yang

BEIJING – China’s economy is, at long last, undergoing a rebalancing, with growth rates having declined from more than 10% before 2008 to roughly 7.5% today. Is this China’s “new normal,” or should the country anticipate even slower growth in the coming decade?

China’s rebalancing is apparent, first and foremost, in the export sector. Export growth has slowed from its 2001-2008 average of 29% annually to below 10%, making foreign demand a far less critical engine of growth.

Moreover, manufacturing employment and output, as a share of the total, began to decline last year. In fact, in the first half of this year, services accounted for more than half of total economic growth. It is no surprise, then, that China’s current-account surplus has shrunk rapidly, from its 2007 peak of more than 10% of GDP to about 2% of GDP today.

This rebalancing has helped to improve China’s income distribution. Indeed, in recent years, labor’s share of national income has been on the rise – a direct reflection of the decline in manufacturing and expansion in services.

That has meant greater regional balance as well: The coastal provinces, which produce more than 85% of the country’s exports, are experiencing the most pronounced slowdown, while inland provinces have maintained relatively high growth rates. As a result, China’s Gini coefficient (a 100-point index of inequality, in which zero signifies absolute equality and one absolute inequality) fell to 0.50 in 2012, from 0.52 in 2010.

Two principal factors are driving this shift. The first is the decline in global demand in the wake of the 2008 financial crisis, which has forced China to adjust its growth model sooner than anticipated. The second is China’s ongoing demographic transformation. The share of working-age people (16-65 years old) in the total population has been declining since its 2010 peak of 72%. And the absolute number of working-age people has been falling since 2012.

At the same time, China is undergoing rapid urbanization, with some 200 million people having left the agricultural sector in 2001-2008 to seek urban manufacturing jobs. More recently, however, the pace of migration has slowed substantially, with rural areas retaining 35% of China’s total labor force.

All of this implies lower growth rates for China – though perhaps not as low as the 6-7% rates that economists like Liu Shijing and Cai Fang are predicting for the next decade. In fact, relying on China’s past growth record to predict future performance is inherently problematic, owing not only to important shifts in the labor force, but also to the fact that the speed and scale of China’s pre-2008 growth was unprecedented.

For starters, it is likely that the contribution to output growth of the rising ratio of working-age people prior to 2010 was overestimated. That makes the subsequent decline in the ratio an inaccurate measure with which to determine the negative impact on economic performance.

Moreover, this approach neglects the educational dividends that China will enjoy over the next 20 years, as the younger generation replaces older workers. As it stands, the rate of return-adjusted educational attainment for Chinese aged 50-60 is half that of those aged 20-25. In other words, young workers will be twice as productive as those entering retirement.

Indeed, the level of educational attainment in China continues to improve. By 2020, the share of those aged 18-22 who are pursuing a college education will reach 40%, compared to 32% today. This improvement in human capital is bound to offset, to some extent, the net loss of labor.

Furthermore, China’s low retirement age – 50 for women and 60 for men – provides policymakers with considerable room to maneuver. Increasing the retirement age by just a half-year for each of the next ten years would more than compensate for the annual decline in the labor force, which is projected to be 2.5 million workers during this period.

Other trends are boosting China’s prospects further. Though investment is likely to decline as a share of GDP, it will probably take a decade for it to dip below 40% – still robust by international standards. Meanwhile, the capital stock can maintain a reasonable growth rate.

Finally, China’s capacity for innovation is improving steadily, owing to rapidly increasing human capital and rising investment in research and development. By next year, Chinese R&D expenditure, at 2.2% of GDP, will be closing in on advanced-country levels.

Based on these trends – and assuming a constant labor-participation rate – China’s potential growth rate over the next decade is likely to hover around 6.9-7.6%, averaging 7.27%. This may be much lower than the 9.4% average growth rate in 1988-2013, but it is more than adequate by global standards. If this is China’s “new normal,” it would still be the envy of the rest of the world.